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C03: Shadow banking

“Shadow banking" is a broad term referring to credit intermediation outside of regulated institutions. Shadow banks accept funds of other parties in order to invest them on their own account. These institutions were partly responsible for the financial crisis of 2007/08, yet the theoretical literature on the topic is still narrow. We devise an adequate framework for dealing with the systemic risks from shadow banking and provide recommendations for improved regulation and supervision.

 

Project members

 

Discussion papers (C03)

 

Motivation

Shadow banks enrich the set of feasible financial contracts. Shadow banks carry out functions of traditional banks, but are subject to lighter or no regulation. Financial competition with shadow banks is ill understood, with few theoretical models.

Policy relevance

Repos and securitizations have been at the heart of the financial crisis of 2007/08.To safeguard financial stability, it is important to understand shadow banks as competitors and complements to traditional banks. Shadow banks should be regulated, but the optimal regulation is subject to debate. The regulation of traditional banks may even be dangerous if the shadow part of the financial system is insufficiently regulated.

Project Plan

Work package 1 - Private backstop for funds

  • Special purpose vehicles, an important part of shadow banking, are often sponsored by commercial banks. In repeated interactions, these banks may implicitly be exposed to the vehicle, and indirectly to its investors.
  • We analyze conditions under which such obligations can emerge and discuss whether, in financial crises, such implicit obligations may be preferable to explicit obligations or true divestitures.

Work package 2 - FinTechs

  • FinTechs provide bank-like services, such as crowd-funding through electronic platforms, but are not banks. They structurally depend on traditional banks because of liquidity constraints or transactional services based on trust.
  • We analyze this non-trivial (partly competitive and partly complementary) interrelationship between FinTechs and traditional banks.

Work package 3 - Competition between commercial banks and non-bank financial intermediaries

  • Central banks may find it optimal to rescue shadow banks in distress. Anticipating this, shadow banks may take too much risk or have too large a maturity mismatch.
  • We study maturity transformation in a model with both commercial and shadow banks in order to analyze aggregate risk and vulnerabilities of the banking system.

Work package 4 - Liquidity and collateral

  • When liquidity dries up, investors withdraw funds from both banks and shadow Bank - potentially in an asymmetric manner. Even with identical net stable funding and liquidity coverage ratios, the volatility of liquidity may differ.
  • We analyze policies that address the problem of asymmetric liquidity structures.

Work package 5 - Banks and shadow banks as platforms

  • Banks and shadow banks can be interpreted as two-sided markets.
  • We want to explore the extent to which the relevant network externalities depend on the precise financial structure of the intermediaries' assets and liabilities, and on potential additional implicit commitments.

Work package 6 - The market structure of repo banking

  • Endogenizing short-term debt (in co-existence with repo funding) is conceptually difficult as final investors are indifferent about the amount of short-term funding they provide to individual shadow banks if competition equalizes their interest rates.
  • We conjecture that the externality imposed by a collective failure induces shadow banks to take on too much short-term debt compared to a zero-failure benchmark.
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